How To Find the Best Sector ETFs

David Trainer | May 31, 2013

Finding the best ETFs is an increasingly difficult task as there are more and more to choose from every day.

You Cannot Trust ETF Labels

There are at least 43 different financial sector ETFs. There are at least 172 ETFs across all sectors. Do investors need 43 different financial sector ETFs or 172 ETFs for 10 sectors? How different can they be?

Those 43 financial sector ETFs are very different. With anywhere from 20 to 520 holdings, many of these ETFs have drastically different holdings, which creates drastically different investment implications.

I am sure that most of them hold the big names in the sector such as Citigroup (C), Bank of America (BAC) and JP Morgan (JPM). However, investors need to know what else those ETFs hold before they can gain a fair understanding of the ETF.

The same is true for the ETFs in any sector as each sector offers a very different mix of good and bad stocks. Some sectors have lots of good stocks and offer lots of good ETFs. The opposite is true for others. And some sectors lie somewhere in between with a fair mix of good and bad stocks. For example, the financial sector, per my 2Q Sector Rankings report, ranks last out of the 10 major sectors when it comes to providing investors with quality ETFs. The consumer staples sector ranks first. The industrials and materials sectors are in the middle. Details on the Best & Worst ETFs in each sector are here.

Investors simply cannot trust the ETF labels.

Figure 1: Best Sector ETFs

Sources: New Constructs, LLC and company filings

Paralysis By Analysis

The large number of financial (or any other) sector ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As mentioned earlier, that can be as many as 520 stocks for one ETF, sometimes even significantly more.

Any investor, worth his salt, knows that knowing the holdings of an ETF is critical to finding the best ETF.

The Danger Within

Why do investors need to know the holdings of ETFs before they buy? They need to know to be sure they do not buy an ETF that might blow up. Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. As Barron’s says, investors should know the Danger Within. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad.

PERFORMANCE OF ETF’s HOLDINGs = PERFORMANCE OF ETF

Finding the Sector ETFs with the Best Holdings

Figure 1 shows my top rated ETF for each sector. Importantly, my ratings on ETFs are based primarily on my stock ratings of their holdings. My coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of the stocks each ETF holds.

Vanguard Consumer Staples ETF (VDC) is not only the top-rated consumer staples sector ETF, it is the highest-rated ETF of the 172 sector ETFs I cover. However, most of the top-rated ETFs for a given sector are not very good. For example, Vanguard Telecom ETF (VOX) is the top-rated telecom sector ETF and it only gets two out of five stars. The same is true for Utilities Select Sector SPDR (XLU).

Encouragingly, only one of the best sector ETFs, PowerShares KBW Property & Casualty Insurance Portfolio (KBWP), suffers from inadequate liquidity. I recommend investors only buy ETFs with more than $100 million in assets. The fact that 9 out of the 10 best sector ETFs have over $100 million in assets, and 8 out of 10 have more than $1 billion, suggests that investors are getting better at identifying the best sector ETFs. Last quarter, only 4 out of the 10 best sector ETFs met my $100 million liquidity standard.

My ETF rating also takes into account the total annual costs, which represents the all-in cost of being in the ETF. This analysis is simpler for ETFs than funds because they do not charge front- or back-end loads and transaction costs are incurred directly. There is only the expense ratio, which is normally quite low. However, my ratings penalize those ETFs with abnormally high expense ratios or any other hidden costs.

Top Stocks Make Up Top ETFs

McDonald’s Corporation (MCD) is one of my favorite stocks in Consumer Discretionary Select Sector SPDR (XLY) and earns my Attractive rating. MCD has grown after-tax profit (NOPAT) by 8% compounded annually over the past 14 years. It has a top-quintile return on invested capital (ROIC) of 16%, and itseconomic earnings margin (ROIC-weighted average cost of capital WACC) has increased in 9 out of the past 10 years. One would expect MCD to be priced for a decent amount of growth given its track record, but that is not the case. At its current valuation of ~$101.20/share, MCD has a price to economic book value ratio of 0.98, implying that its NOPAT is actually going to permanently decline slightly. At such a low valuation, MCD represents a great value for investors.

XLY has Attractive total annual costs of just 0.20%, but what makes it the top-rated Consumer Discretionary ETF is its allocation to high quality stocks like MCD. Low costs are nice, but in the end it’s the holdings that drive the performance of any ETF.

Sam McBride contributed to this report

Disclosure: David Trainer owns MCD. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.